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Posted about 5 years ago

A Brief Overview of Qualified Opportunity Zones

Introduction

Qualified Opportunity Zones (“QOZ”) were created by the 2017 Tax Cuts and Jobs Act. The purpose of QOZ is to incentivize economic investment and development in designated low income and distressed communities throughout the United States. Economic encouragement in designated QOZ is created through federal income tax benefits to taxpayers who newly invest in businesses or properties located within selected economically distressed communities. Specifically, QOZ offer investors opportunities to defer realized gains if the proceeds from the sale of capital assets are invested in QOZ. It is estimated that there are over $6.1 trillion dollars of unrealized gains in U.S. assets. On November 14, 2018, the Wall Street Journal reported at least 43 funds were seeking to raise a total of $8.9B to invest in QOZ. In late October 2018, Treasury Secretary Steven Mnuchin estimated $100B in capital investment will flow into QOZ. If even a small portion of the accumulated unrealized gains in the U.S. are invested in the chosen distressed communities, the program would be one of the largest federal community development initiatives in U.S. history.

What are Qualified Opportunity Zones

QOZ are low-income areas determined by the Governors of each state. 8,700 economically distressed areas have been identified by each state and approved by the Treasury Department. Generally, the designated communities have an average poverty rate of nearly 32% and an unemployment rate of 13%. The Community Development Financial Institutions Fund has created an interactive map of all designated QOZ.

Parties Eligible to Invest in QOZ

Any taxpayer that recognizes capital gains for federal income tax purposes is eligible to invest in a QOZ. These taxpayers include individuals, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships, and certain other pass-through entities.

Qualified Opportunity Fund

Qualified Opportunity Funds (“QOF”), not to be confused with QOZ, is an investment vehicle that invests over 90% of its assets in qualified opportunity zones. QOF are the structural framework the IRS has chosen to regulate investments in QOZ. The IRS has been deliberately vague on the structural requirements of QOF. Some QOF will be structured as a disregarded entity with one member holding one asset. Other QOF will be structured as a corporation with many shareholders and many assets. The main criteria is that the investor’s interest in the QOF is equity interest. Initial funding for investments into a QOF can come from any capital gain. A QOF may be organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property. To become a QOF, the eligible entity must self-certify as a QOF on IRS Form 8996 and specify the first month in the initial tax year that the eligible entity desires to qualify as a QOF.

Qualified Opportunity Zone Investments

The two types of property that qualify for Opportunity Zone investments are real estate and active trades or businesses.

  1. Real Estate - the property must be located in the designated Opportunity Zone tract. The real estate must be substantially improved. Substantial improvements are improvements to the property greater than or equal to the basis in the original building. The basis in the land is not included in the substantial improvement calculation. Taxpayers have 30 months from the date of the acquisition of such property to make required improvements.
  2. Active Business - the business must own or lease at least 70% all of its tangible property in the QOZ tract. Further the business must generate at least 50% of its gross income from active trade or business conducted within the QOZ. Additionally, the business cannot be a private or commercial golf course, country club, massage parlor, hot tub facility, sun tan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.

Tax Incentive of Investment in QOZ

Investments in QOZ offer economic tax incentives by allowing taxpayers with realized capital gains, to defer and potentially decrease their tax liability by reinvesting the gains into a QOZ. A gain is eligible for deferral if it is treated as a capital gain for federal income tax purposes. Investment in QOZ may provide three tax incentives to investors:

  1. Deferral of capital gain;
  2. Possible reduction of the amount of gain ultimately recognized through a basis adjustment; and
  3. Forgiveness of additional gain in the QOZ investment.

Capital gains are excess gains from the sales or exchanges of capital assets over the losses from such sales or exchanges. Only capital gains arising from the sale or exchange of capital assets before December 31, 2026, are eligible for deferral treatment. Investors must invest in a fund within 180 days after the sale or exchange of the capital asset. The tax incentive is not a permanent tax shield. Taxes will be due on the deferral of the capital gain at the time of the disposition of the QOF or by December 31, 2026, whichever is sooner. Deferred capital gains basis is increased by 10% if the investment is held by the taxpayer for at least 5 years and by an additional 5% if held for at least 7 years, thereby excluding up to 15% of the original gain from taxation. Additionally, if the investment in the QOF is held for at least 10 years, the taxpayer receives a stepped-up basis in the QOF investment to fair market value at the time of the sale. This results in a permanent exclusion of tax for gain from investments in QOF held for more than ten years.

Conclusion

Qualified Opportunity Zones are an exciting new incentive to direct private capital into blighted regions in the United States. Opportunity zones entice taxpayers to invest in chosen areas through capital gains tax liability deferral and potential tax liability reduction. The goal of the initiative is to influence private investors to convert unrealized gains into impactful economic development. It is too early to tell whether the initiative will spur economic growth in the communities it is meant to uplift. Qualified Opportunity Zones have the potential to dramatically revitalize long forgotten communities throughout the United States and change the lives of innumerable citizens.

Example

The difference in overall return on investments may be staggering depending on how long the QOF is held. In the below illustrations we assume a flat 23.8% tax rate and a 10% annual rate of return on all investments.

1. Mark, an individual taxpayer, sells stock A and realizes $100,000 in capital gain on January 1, year 1. Mark has until June 30, year one to invest his gross proceeds from the sale of stock A into a QOF. Mark finds an eligible QOF to invest the proceeds on June 30, year 1. Mark sells his interest in the QOF on December 31, year 3 for $133,100. Since Mark re-invested his capital gain in a QOF, he is eligible to defer his tax liability on the $100k gain until he sells his interest in the QOF on December 31, year 3. Here Mark’s tax benefit to invest in a QOF is a three-year deferral on the tax liability of his capital gain of $100k. In other words, Mark has an extra $23,800 ($100,000*23.8%) to invest in year one. If Mark had instead invested the proceeds from his realized capital gain into a stock portfolio, his principal left after taxes would have been $76,200 ($100,000-$23,800). Mark’s ability to leverage his deferred taxes into a QOF resulted in after-tax proceeds of $101,422 opposed to $77,284 if Mark had invested his after-tax capital gain proceeds from stock A into a stock portfolio paying a similar return.

Normal 1547838620 Ex1

2. Same facts as number 1, except Mark sells his interest in the QOF on December 31, year 7 for $194,872. Since Mark re-invested his capital gain in a QOF, he is eligible to defer his tax liability on the $100k gain until he sells his interest in the QOF on December 31, year 7. Additionally, since Mark held his investment in the QOF for over 7 years he gets a stepped up basis in his original capital gain of 15%. Mark’s ability to leverage his deferred taxes into an income producing investment resulted in after-tax proceeds of $152,062 opposed to $113,151.

Normal 1547838678 Ex2


3. Same initial facts as example 1 and 2, except Mark sells his interest in the QOF on December 31, year 10 for $259,374. Since Mark re-invested his capital gain in a QOF, he is eligible to defer his tax liability on the $100k gain until December 31, 2026. Additionally, since Mark held his investment in the QOZ for over 7 years he gets a stepped up basis in his original capital gain of 15% on December 31, 2026. On December 31, 2026 Mark pays $20,230 on his deferred capital gain of $100,000. Finally, since Mark held his investment in the QOF for over ten years, his basis in the QOF investment is increased to fair market value at the time of the disposition. Mark’s ability to leverage his deferred taxes into QOF property resulted in after-tax proceeds of $239,144 opposed to $154,174 if invested in a stock portfolio paying a similar return.

Normal 1547838808 Ex3

Revenue Ruling 2018-29

https://eig.org/news/opportunity-zones-tapping-6-trillion-market

https://thehill.com/hilltv/rising/408980-mnuchin-predicts-100b-in-cap-investment-from-new-opportunity-zones

IRC 1400Z-1(a)

Schultz, Abby. “How Foundations Are Shapping ‘Biggest Experiment’ of Opportunity Funds.” Baron’s October 30, 2018.

The Urban Institute, a U.S. think tank.

REG 115420-18

id.

IRC 1400Z-2(d)

IRC 1400Z2(2)(D)(ii).

id.

IRC 1400Z-2(d)(3)(A)

REG - 115420-18

IRC 1400Z-2(b)

IRC 1400Z-2(b)(2)(B)

IRC 1400Z-2(c)

Capital Asset - property held by the taxpayer, but does not include (1) inventory held in the taxpayer’s business for sale to customers in the ordinary course of his trade or business, (2) property used in the taxpayer trade or business, (3) intellectual property created by the taxpayer, (4) accounts or notes receivable acquired in the ordinary course of trade or business, (5) zero coupon obligations (bonds) of the United States issued after March 1, 1941 with a fixed maturity not exceeding one year from the date of issuance, (6) commodities derivative financial instruments held by a commodities derivatives dealer, (7) hedging transaction, or supplies used or consumed by the taxpayer in the ordinary course of a trade or business. IRC 1221

IRC 1229(9)

IRC 1400Z-2(b)(1)(B)

IRC 1400Z-2(b)(1)(B)

IRC1400Z-2(a)(2)

$130,374=(85,000*23.8%)+ (97,643*23.8%). $20,230 (85k*23.8%) is paid at December 31, 2026.

[i] Information contained in this article is for the general education and knowledge of readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation consult competent legal counsel.



Comments (3)

  1. @Spencer Hogan it is unclear whether the gains in a Qualified Opportunity Fund can be re-invested into new qualifying assets within a QOZ. The answer to this question has been requested by many interested parties. The Treasury released proposed regulation on Opportunity Zones on October 19, 2018. The Treasury and IRS have invited additional public comment on the scope of statutorily permissible policy alternatives. Until Treasury releases additional guidance or final regulations we are in limbo.


    1. Thank you @Matt Chodosh. That is my understanding as well. This seems like an important question given that a fund's reinvestment strategy has an impact on risk / returns to the investor. I am somewhat surprised that investors are signing up for OZ Funds without some of these questions answered. 


  2. @Matt Chodosh Great post. Thank you for sharing the info. How are you interpreting the hold period at the real-estate level? I understand that the investor needs to hold its ownership interest in the OZ Fund for at least 10 years to potentially receive all the tax benefits but can the OZ Fund buy, improve, and then sell qualified OZ properties and immediately reinvest the proceeds back into qualified OZ properties and still qualify for all the tax benefits?

    For example, if an OZ Fund invests in a qualified OZ development project, can the OZ Fund sell the property once stabilized and reinvest the proceeds into another OZ development project or is the OZ Fund stock with its initial development project?

    Thank you,

    Spencer